Canada and the US have almost hundred-year histories of regulating investor-owned utilities. This shared experience is different from almost all of the rest of the world, where the appearance of investor-owned (i.e., private) utilities came only with the privatization wave of the late 20th century. The regulatory laws, mechanisms, and institutions in those other countries are new—and in many cases untested. But longstanding regulatory institutions in Canada and the US have for decades been helping to provide safe and adequate services to the public at reasonable prices while ensuring that the companies involved remain “going concerns” with sufficient credit worthiness to attract the capital needed to maintain and expand their facilities.
Over the past decade, however, a significant difference has appeared in the regulatory practices between Canada and the US. In an effort to improve regulatory efficiency, Canadian regulators—first in British Columbia, then more widely—moved away from the case-by-case approach to determining the fair return on equity (ROE) for utility ratemaking purposes. Canadian regulators adopted generic, formula-based approaches to deriving the admittedly elusive fair ROE. US regulators in the 1980s and 1990s made two tries at generic, formula-based approaches to setting the ROE (one at the federal level and one in the State of New York), but, in the end, did not abandon their longstanding, case-by-case methods that rested on two existing and long-accepted financial theories.
In this report for the Canadian Gas Association, NERA analyzes the root causes of this disparity between Canadian and US ROEs that has apparently been propelled—either directly or indirectly—by the Canadian ROE adjustment formula. Since the “appropriate” level of ROE is driven by the risk/return requirements of those utility investor-owners, the authors investigate whether Canadian utilities face sufficiently less risk than their US counterparts, as well as whether the difference in allowed returns for ratemaking is merely a symptom of a structurally inflexible formula rather than an indicator of underlying risk differences. If it is the latter, then Canadian regulators have indeed streamlined rate cases for the better. If the former, then perhaps the formula has had unintended consequences and is in need of updating to better reflect the market's judgment on the cost of equity of regulated Canadian utilities.